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Central Bank: questions of autonomy and the mandate

The discussion of central bank autonomy is not new in Brazil, but it has resurfaced in recent months

• Discussions about autonomy at the Brazilian central bank (BCB) are not new, but they gained momentum in recent months, including the debate over the mandate that should be pursued.

• We analyzed a sample of 31 central banks. Only Brazil and four others in the sample do not ensure formal autonomy to their central banks. In our sample, laws tend to prioritize price stability.

• Along with analysis of the prevailing legal framework, we modeled the potential impact of the adoption of a dual mandate (inflation and employment) in Brazil. We show that the adoption of a dual mandate would result in higher inflation and de-anchored expectations, without long-term gains in employment. In our view, price stability — and not a dual goal — is the best way for the local central bank to contribute to sustainable economic growth.

Recently, the government presented an agenda of 15 priorities to reduce federal expenses, update tax legislation and strengthen the domestic economy. One of these points addresses central bank autonomy and the nomination, tenure and removal from office of its governor and directors. The possibility of a dual mandate (i.e., a mandate that sets two explicit goals for monetary policy: controlling inflation and employment levels) was also put on the table.

We outline below the mandates and the degrees of autonomy for several central banks around the world, and we explain why establishing a dual goal may undermine monetary policy in Brazil’s case.

The issue of central bank autonomy

Advocates of central bank autonomy argue that this body should work with clear and simple goals and with enough authority to attain them, so that it can maintain its credibility. A credible central bank has greater capacity to influence inflation expectations while supporting price stability with lower volatility in terms of interest rates and employment. Furthermore, autonomy is key to protecting central banks from possible political interference – reducing the risk of fiscal dominance, for instance.

The main argument against autonomy, on the other hand, is the lack of democratic legitimacy, given that central bank governors and directors are not elected by the population (the same applies to heads of regulatory agencies).

According to Grilli, Masciandaro and Tabellini (1991), the degree of autonomy for a central bank has two components: i) political autonomy, as in defining final objectives/goals, and ii) economic autonomy, as in the instruments used to achieve goals.

The U.S. Federal Reserve stands out as the one with the greatest autonomy. In addition to its freedom in terms of instruments, the Fed can interpret its legal mandate, giving priority to one out of three goals set by the Federal Reserve Act (maximum employment, stable prices and moderate long-term interest rates)[1]. The European Central Bank’s goal of price stability is very clearly defined by lawmakers[2]. Like the Fed, the ECB also has autonomy to set the quantitative target that will be pursued. The same goes for the Czech Republic, Sweden, Chile and Mexico.

However, other central banks only have economic (or operational) autonomy. In these cases, the government (often working together with the central bank itself) sets the goals of monetary policy, and the central bank has the autonomy to select the instruments it considers best for pursuing those goals. This is the case in Australia, Canada and Colombia, among other countries.

We studied the autonomy of 31 central banks[3], of which only five have no formal autonomy (i.e., set by law). These are Brazil, Thailand, Poland, Norway and China.

International experience: diverse central bank mandates

We also studied the mandates of these 31 central banks, and the following aspects stood out:

Only the U.S. Fed has a multiple mandate, i.e., more than one explicit goal. Importantly, the Fed enjoys political autonomy, and historically it has pursued its mandate without political interference.

Nowadays, the most common mandates emphasize price stability or currency stability[4] (23 of 31 central banks, or almost 75%).

Some central banks have a priority mandate, with specific support for other economic policies as long as these do not clash with its primary goal. This is the case for the ECB and the central banks of Hungary and Israel. For instance, the priority is price stability, but if there is no prejudice to this goal, the central bank may support other economic policies that seek to contribute to growth.

Some central banks have a complex mandate, i.e., there is no priority goal clearly set forth by law. This is the case in Brazil and six other countries.

Autonomy and the mandate of the Brazilian Central Bank

The BCB has no formal autonomy (political or economic). Although it works with de facto autonomy, this is not established by law (de jure). The President of the Republic pledges not to interfere in its technical decisions, but nothing is written about the matter.

Law 4595, enacted in 1964, establishes that “It is the responsibility of the Central Bank of the Republic of Brazil to comply with and ensure compliance with the provisions attributed to it by current legislation and norms issued by the National Monetary Council”. In other words, the BCB’s goals are fully subordinated to the National Monetary Council (CMN), and there is no priority goal clearly established in the law.

In our view, the proposal of establishing formal economic (or operational) autonomy with price stability as a priority goal, would boost the credibility and effectiveness of monetary policy. The inflation target, in turn, should continue to be set by the CMN (a council formed by the Ministers of Finance and Planning and the BCB Governor), so as to ensure the democratic legitimacy of the inflation targeting regime. But even in this case, the BCB would still lack political autonomy.

Would the adoption of a dual mandate in Brazil be worth it?

Investigating how central banks make decisions under an inflation-targeting regime is useful when considering the effectiveness of a dual mandate. Monetary policy decisions (i.e., the determination of nominal interest rates) in such a regime may be described, in a simplified manner, by a Taylor Rule. Broadly speaking, this rule establishes that interest rates depend on inflation expectations (an increase in inflation by 1 pp should prompt a 1.5 pp increase in nominal interest rates) and on the unemployment rate (an increase of 1 pp in unemployment should prompt a 0.5 pp decline in nominal interest rates). The Taylor Rule can be summarized in the equation below (1).

In this equation, i is the nominal interest rate, ΠM and ΠE are the inflation target and expected inflation, respectively, r* is the neutral real interest rate[5], u and u* are the unemployment rate and NAIRU[6], respectively.

It is important to note that, based on the abovementioned rule, even if central bank mandates do not specify unemployment as a goal, they do react to changes in this variable, for two reasons. First, monetary authorities tend to reflect social preferences and are thus sensitive to fluctuations in employment levels. Second, because the unemployment rate is one of the main drivers of inflation, it must be considered even when the goal is limited to price stability.

So what is the problem with a formal target for employment?

The biggest problem is that, in the long run, the monetary authority is able to influence nominal variables, but not real variables. Given the neutrality of money principle, changes in the stock of money affect only nominal variables (such as inflation), but they have no impact on production, employment or income levels, for instance. In other words, if monetary policy was able to affect economic growth or the unemployment rate in the long term, it would make sense to set targets for these variables, and they would probably contribute to social well-being. Unfortunately, monetary policy cannot deliver this. In fact, Brazilian experience shows that greater tolerance of inflation cannot buy economic growth.

Although the central bank is able to affect long-term inflation, it cannot control the neutral real interest rate (r* – which depends on the savings rate and fiscal policy), the long-term unemployment rate (u* – which depends on labor legislation) or the economic growth rate (which depends on demographic variables, productivity and more).

Thus, pursuing a dual mandate entails risk. Let’s assume that the monetary authority would not only pursue an inflation target, but also an unemployment target, represented by uM in the equation below. When a central bank has a dual mandate, the Taylor Rule (1) described above may be re-written as follows:

In the long run, due to money neutrality (i.e., considering that u = u* and i = r* + ΠE), equation (2) may be re-written as follows:

Equation (3) shows that the greatest risk related to the adoption of a dual mandate is setting an unemployment target (uM) below neutral unemployment (u*) – i.e., an unemployment target that would ultimately be inflationary. In other words, the pursuit of below-neutral unemployment would result in higher inflation and de-anchored expectations, without gains in employment in the long run[7].

This is not to say that society should not pursue policies that seek a low unemployment rate in the long term. Quite the opposite. Obviously, persistently-high unemployment entails substantial economic and (most noticeably) social costs. Low unemployment should be a priority of the overall economic policy, and many actions can and ought to be implemented, such as strengthening education, streamlining labor legislation, etc. However, using monetary policy to that end tends to deliver innocuous results in terms of employment, which are also counterproductive in terms of inflation in the long run.

Conclusion

The discussion of central bank autonomy is not new in Brazil, but it has resurfaced in recent months. Along with it came the debate over the monetary authority’s legal mandate. International experience shows that the vast majority of central banks nowadays have formal autonomy, and the most common mandate prioritizes price stability.

In our view, autonomy for the Brazilian central bank would increase its credibility and the effectiveness of monetary policy. Adopting a dual mandate, however, would not generate positive effects. In the long run, the monetary authority has no control over real variables, so that establishing a dual goal could produce just higher inflation and de-anchored expectations, without gains in employment.

[1] "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates"

[2] "The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies "

[3] The central banks in our sample and a detailed table are included in the Appendix.

[4] The formula that emphasizes price stability is preferable to currency stability, which may be interpreted as exchange rate stability, for instance.

[5] The neutral interest rate is usually defined as one which is consistent with potential output and, consequently, on-target inflation (assuming a credible inflation-targeting regime). The concept is useful to characterize the monetary policy stance over time: when the interest rate is below its neutral level, monetary policy will be expansive, stimulating aggregate demand and leading to a positive output gap (i.e., GDP above potential) and above-target inflation. On the other hand, if the interest rate is above its neutral level, monetary policy will be contractionist, reducing aggregate demand and leading to a negative output gap and below-target inflation.

[6] The non-accelerating inflation rate of unemployment (NAIRU) is the one that keeps inflation constant (no inflationary/deflationary pressures arising from the labor market).